DP16628 Bank Use of Sovereign CDS in the Eurozone Crisis: Hedging and Risk Incentives

Author(s): Viral V. Acharya, Yalin Gündüz, Tim Johnson
Publication Date: October 2021
Keyword(s): credit default swaps, Credit derivatives, Depository Trust and Clearing Corporation (DTCC), Eurozone, sovereign credit risk, sovereign debt crisis
JEL(s): G01, G15, G21, H63
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16628

Using a comprehensive dataset from German banks, we document the usage of sovereign credit default swaps (CDS) during the European sovereign debt crisis of 2008-2013. Banks used the sovereign CDS market to extend, rather than hedge, their long exposures to sovereign risk during this period. Lower loan exposure to sovereign risk is associated with greater protection selling in CDS, the effect being weaker when sovereign risk is high. Bank and country risk variables are mostly not associated with protection selling. The findings are driven by the actions of a few non-dealer banks which sold CDS protection aggressively at the onset of the crisis, but started covering their positions at its height while simultaneously shifting their assets towards sovereign bonds and loans. Our findings underscore the importance of accounting for derivatives exposure in building a complete picture and understanding fully the economic drivers of the bank-sovereign nexus of risk